Depository Institutions: Banks & Credit Unions

• Depository institutions include commercial banks, savings institutions, and credit unions

Learning Objectives

• Understand the different types of depository institutions
• Understand the major activities of commercial banks
• Understand the structure of a bank's balance sheet and its components: assets, liabilities, and capital
• Understand the key performance ratios of banks
• Understand the different activities of saving institutions and credit unions
• Understand the regulatory framework governing the activities of depository institutions

Depository Institutions (DIs)

• DIs get a significant portion of their funds from customer deposits
• The three types are Commercial Banks, Thrifts which include Savings Institutions and Credit Unions

Historical Focus of Depository Institutions

• Commercial Banks primarily focused on business loans and securities investments
• Savings Institutions focused on mortgage loans
• Credit Unions focused on consumer loans
• Differences between these institutions have faded due to competition, changing regulations and technology

Commercial Banks

• Commercial Banks are the largest type of depository institution
• They are stock ownerships run by an appointed board
• Commercial Banks accept deposits (liabilities) and then make loans (assets)
• Loans include residential, business, and consumer loans
• Banks have recently been heavily concentrated in residential loans
• Non-deposit liabilities include bonds, Fed funds borrowed, and repos
• Commercial Banks have separate regulations from thrifts

Commercial Bank History

• Leading up to the 80s the number of commercial banks shrunk
• The consolidation primarily occurred through mergers and acquisitions
• JP Morgan acquired Chase Manhattan for $33.6 Billion in Sept. 2000
• Norwest acquired Wells Fargo for $34.3 Billion in June 1998
• Bank of America purchased FleetBoston Financial for $49.3 Billion in Oct. 2003
• JP Morgan Chase purchased Bank One for $60 Billion in Jan. 2004

Types of Commercial Banks

• Community Banks: Smaller banks with under $1 Billion in assets specializing in retail banking focusing on residential and consumer loans
• Regional or Superregional Banks: Larger banks with over $1 Billion in assets engaging in wholesale banking focusing on residential, consumer and C&I (business) loans
• Large banks can access the Fed Fund market for financing
• Large banks typically have narrower spreads
• Money center banks rely more on borrowed funds
• Large banks rely on off-balance sheet activities
• Large banks use models and centralized decision making
• Small community banks use relationship banking and personal knowledge of customers

Balance Sheet Basics

• Federal Funds Market: An interbank market for short-term borrowing and lending of bank reserves between banks
• Spreads: The difference between bank's lending rates and bank's deposit rates
• Money Center Banks: Banks with a heavy reliance on non-deposit or borrowed sources of funds
• Off-Balance Sheet (OBS) Activities: Financial transactions that do not directly impact a bank's balance sheet but can have significant implications for its financial condition.
• Return on Assets (ROA) and Return on Equity (ROE) are frequently used to measure performance.
• Bank assets are loans and other assets
• Bank liabilities are deposits and other liabilities

Balance Sheet Structure

• Bank assets include: Property, trading assets, loans to customers and deposits to the central bank
• Bank liabilities include: Loans from the central bank and interbank market, deposits from customers, trading liabilities
• A bank's equity includes common and preferred shares
• The balance sheet equation states: Assets = Liabilities + Equity

Bank Revenue

• The major source of revenue comes from the difference between the interest rates they receive on loans and the interest they pay on deposits
• Loans to customers are assets because banks will receive interest and principal repayments
• Deposits customers make are liabilities because the customers can withdraw

Central Bank Deposits and Loans

• Deposits from a bank in a central bank are considered assets, similar to cash equivalents
• Banks can also take loans from the central bank, and these are considered liabilities

Trading Assets and Liabilities

• Banks may hold marketable securities or certain currencies for trading with these items being trading assets
• Trading liabilities consist of long term liabilities (bonds) and short positions (CDs)

Typical Income Statement Structure

• Non-interest Revenue
• Interest Revenue
• Credit loss provisions
• Net gain on trading assets/liabilities
• EBIT
• Interest Expense
• Income Before Tax (EBT)
• Taxes
• Net Income

Income Statement Items

• Non-interest revenues are ancillary revenue such as broker fees, commissions and fees from products and services, and gain on sale of trading assets
• Interest revenue includes interest payments the bank earns on loans (less interest expense)
• Credit Loss Provisions are an expense set aside for potential borrower defaults

Uses and Sources of Funds

• Uses of Funds (Assets): Residential mortgages (and MBS), consumer and business (C&I) loans, and securities investments (marketable and investment securities)
• Sources of funds (Liabilities): Deposits, Non-deposit borrowed funds (short and long term), Equity (Net Worth)
• Commercial banks have two major sources of funds other than equity
• These are from deposits such as transaction accounts and savings accounts.
• The second source of funds is non-deposits through borrowed funds (short and long term), Repos, Fed Funds, Fed discount loans, and bonds.
• Banks are highly leveraged (low equity relative to assets)

Sources of Funds

• Banks get depository sources from Transaction Accounts, Saving Deposits, Time Deposits, and Money Market Deposit Accounts (MMDA)

Depository Sources

• Demand Deposit: Non-interest-bearing checking account
• Negotiable Order of Withdrawal(NOW): Interest-bearing checking account
• Passbook Savings: Interest-bearing savings account
• Automatic Transfer Service ATS: Links demand and savings deposits creating an automatic transfer of funds
• Retail CD: Fixed-maturity interest bearing CDs, under $100k, can be cashed out before maturity with a penalty
• Negotiable CD: Fixed-maturity interest bearing CDs, over $100k, cannot be cashed out before maturity, can be sold in the secondary market
• Money Market Deposit Account: Pays a higher interest rate investing in money market funds with no specific maturity

Non Depository Sources

• Banks also get non-depository sources from Bank Reserves, Fed Discount Loans, Repos, Bonds, Equity
• Bank Reserves: Banks borrow funds from other banks through the Fed fund market (at the Fed fund rate).
• Fed Loans (Discount loans): Banks can purchase (borrow) funds from the Fed through the discount window for short-term loans (at the discount rate).
• Repos (Repurchase Agreements): Banks have short term lending agreements where securities, usually T-bills, are used.
• Long Term Borrowing (Bonds): Long-term sources of funds through notes and bonds.
• Equity: Paid in capital + Retained Earnings + Preferred stock with a minimum of 10% of total assets

Key Definitions

• Discount window: Facility controlled by the Fed (Central bank) where banks borrow money.
• Fed funds rate: Rate at which banks lend/borrow in the interbank market.
• Discount rate: Rate at which banks borrow from the Fed.
• Paid in capital: Capital paid by investors.
• Retained earnings: Accumulated net income that is reinvested.
• Preferred stock: Pays a mandatory dividend, has no voting rights, and carries a higher claim than regular stock.